Does Anglo-Saxon Corporate Governance Matter for Capitalist Development of Emerging Asian Economy? A Case Study of India

Abstract

The voluminous body of law and finance literature argues that legal rules shape economic outcomes as far as they support market-based economic activity. This is what suggested in new institutional economics. It is pointed out that legal protections for shareholders will lead to stock market development and ease the financial constraint for corporate growth through capital formation. In the ‘neo-liberal’ era of privatisation and disinvestments in the existing public sector companies, stock market development is given a top priority in the Washington Consensus. It is expected to provide a market mechanism for private corporate capital accumulation (along with public sector disinvestments) and economic growth. The empirical basis of the ‘law matters’ postulate is by and large cross-sectional. The present paper examines this postulate on the basis of the experience of an emerging Asian economy, India, over a time span of 30 years, namely, 1976-2005. This type of time-series study is made possible by the availability of ‘leximetric’ data from the source of Centre for Business Research at the University of Cambridge, UK (hereafter CBR). This study uses the time-series technique of cointegration and vector error correction modelling that takes into account the short-term relationship (temporary impact) and the stability of the adjustment process through which the short-term relationship (if any) culminates into a long-term relationship (permanent impact, if any). It examines the two-way relationship — whether shareholder protection influences stock market development or changes in stock market scenario create an effective pressure on the lawmakers to introduce legal changes or both. It is not true that the nature of a country’s legal infrastructure is fixed as an endowment. Legal infrastructure often interacts with politico-economic developments and may be altered by them. It can be examined by modelling the two-way relationships. This study will add to the existing literature. It recognises the fact that impact of law on economic variables is not instantaneous – it has a path dependency. The path may not be stable; a short-term outcome (significant or not significant) may not lead to a (significant or not significant) long-term outcome. It may so happen that the nature of the short-term outcome is the polar opposite of the long-term outcome. What is observed in this study challenges the so-called conventional wisdom created by the series of studies by La Porta and his colleagues. It is observed that shareholder protection has no long-term favourable effect on stock market development. At best there is no effect (as in stock market trading) and at worst there is negative effect (as in turnover ratio). The avowed objective of improving corporate governance and granting better rights to shareholders is not just for securing the property right of the property-owners. It also promotes the stock market so that the general public will be encouraged to buy shares issued by the corporate sector, and in the process finance their capital formation and growth. However, changes in India’s shareholder protection did not have this effect – the long-term effect on public subscription of shares is either non-existent or negative. The effect on private corporate capital accumulation in both real and relative terms (relative to aggregate national capital formation) is also negative. It is also observed that increasing shareholder protection leads the corporate sector to move away from the issue of shares to debentures in order to finance corporate capital accumulation. This observation goes hand in hand with the observation of a negative effect of shareholder protection on stock market listings. It is also increasingly recognised that corporate governance reforms can be ‘too much of a good thing.’ A perception of excessive regulation can lead to de-listings, as appears to have been the case with the Sarbanes-Oxley Act. This study also examines whether shareholder protection regulations are influenced by changes in the stock market and corporate growth scenario. In the process of growth and evolution of the stock market and the stock-market dependent corporate sector, as demands for changes in the relevant law come up, law makers cater to this need. In India, an apparently surprising result is derived from the present analysis: by and large negative effect of stock market development and corporate capital accumulation on shareholder protection. It seems that when public subscription of shares, stock market trading and market capitalisation are at low ebb, the regulators tighten the belt while in boom condition they relax the rules. To be more specific, as market capitalisation or equivalently the total value of all shares listed in the stock market (as percentage of GDP) declines Indian regulators tend to increase the minority shareholder protection and as the value of all shares traded in the stock exchange (relative to GDP) declines, Indian regulators tend to increase the shareholder protection relating to board and management. As the stock market listing falls, certain aspects of shareholder protection (captured by the ten variable average index) improve. Declining corporate capital accumulation (in real and relative terms) also prompts the law makers to increase shareholder protection in certain spheres. Despite its useful findings, the scope of the present study has some limitations. First of all, it does not deal with the question of law enforcement. The CBR index is based on the laws on the books – not based on the actual implementation of the laws. There is a view that the rule of law is at a very miserable stage in many emerging countries including India because of corruption and other imperfections. According to several studies conducted by the World Bank, the Indian score for the rule of law has been very low. Unfortunately, since no long time series data are currently available on rule of law, it is not possible to include this factor into the present analysis. Furthermore, this factor does not change frequently over the years, thus complicating the possibility to measure its evolution over time.